Understanding Cost Structure of a Law Firm

Chris Powell | 23-May-2018

In economics, the theory of production attempts to explain the principles by which a business firm decides the best way to maximise its profit. It is premised on the basis that the purpose of a business is to maximise profits[1]. This article draws a comparison between this basic economic theory and suggests that an intricate understanding of a law firm cost structure is the first step to the adoption of any technology.

The theory of production categorises business expenses into fixed and variable expenses and postulates that business firms should continue to produce until the marginal revenue (e.g. price) exceeds its marginal cost. In the context of a law firm, marginal cost consists mainly of the wages (including overtime) and disbursements. Marginal revenue, on the other hand, refers to client billing.

With the increasing commoditisation of legal work, an understanding of the cost structure becomes crucial. Very simply, price movement can have a greater proportional impact on the quantity of legal services demanded. Increase your price and demand drops drastically. Decrease your price below your cost of production and your firm ends up losing money.

In a straw poll on the elasticity of legal services conducted during the 2017 Corporate Counsel event, an overwhelming number of in-house counsel acknowledged the price elasticity of legal services and the presence of a buyer market for legal services in Singapore. Yet, our conversations with legal practitioners operating in the Asia Pacific region affirms our belief which is contained in a study conducted by the Law Society of Australia that very few practitioners have calculated their cost of production[2].

To put in bluntly, the study states that “they [legal practitioners] have absolutely no idea how much it costs them to produce their legal services. Financially, they are just winging it. This is troubling as only by understanding the cost structure of a law firm can a law firm plan, invest, and justify any investment in technology.

To adopt any form of technology without such an analysis would be in the words of a lawyer be considered – negligent.

In the opening of the legal year for 2018, Chief Justice, Sundaresh Menon mooted the idea of a low bono scheme for family disputes. If realised, it would mean legal help at a discounted rate for those who do not qualify for pro bono aid but find it difficult to afford a lawyer[3]. It is submitted that such low bono schemes may soon be the norm as supposed to the exception.

In the ever increasingly competitive legal industry where legal work is commoditized and firms compete on cost, how then should a law firm react? LegalFAB is a firm believer that lower prices need not equate to lower overall profitability of the firm (or profitability per partner). However, only by understanding the cost of production of legal services, the breakdown of a firm clientele can a law firm utilizes technology to achieve greater productivity and attract more clients.

With the introduction of Uber and Grab disruptors in the Singapore taxi industry, a common sight these days is the number of vacant taxis plying the street. Lawyers should not lull themselves into a false sense of security that they stand immune from legal disruptions, or that this is passing fade. In the same vein, the number of legal practitioners that have succeeded by moving to other industries also suggests that technology disruptors in this field should not underestimate the capacity of legal practitioners to innovate.

[1] While we acknowledge that this concept may not be applied wholesale to a profession which involves providing a service to the society at large, we use the example to illustrate the profit-focused of commercial law firms.

[2] As such, for cost-sensitive matters for which a fixed fee has been agreed, client work is normally completed at different levels of seniority, with the aim of reining in the marginal cost of work.